MONEY.

MONEY IS USED FOR BUYING OR SELLING GOODS, FOR MEASURING VALUE AND FOR
STORING WEALTH. Almost every society now has a money economy based on
coins and paper notes of one kind or another. However, this has not
always been true. In primitive societies a system of barter was used.
Barter was a system of direct exchange of goods. Somebody could exchange
a sheep, for example, for anything in the market place that they
considered to be equal value. Barter however was a very unsatisfactory
system because people’s precise needs seldom coincided. People needed a
more practical system of exchange, and various money systems developed
based on goods, which the members of a society recognized as having a
value. Cattle, grain, teeth, shells, features, skulls, salt, elephant
tusks and tobacco have all been used. Precious metals gradually took
over because, when made into coins, they were portable, durable,
recognizable, and divisible into larger and smaller units of value.

A coin is a piece of metal, usually disc-shaped, which bears
lettering, designs or numbers showing its value. Until the 18th and 19th
centuries coins were given monetary worth based on the exact amount of
metal contained in them, but most modern coins are based on face value,
the value the governments choose to give them, irrespective of the
actual metal content. Coins have been made of gold (Au), silver (Ag),
copper (Cu), aluminum (Al), nickel (Ni), lead (Pb), zinc (Zn), plastic
and in China even from pressed tealeaves. Most governments now issue
paper money in the form of notes, which are “promises to pay». Paper
money is obviously easier to handle and much more convenient in the
modern world. Checks, bankers, cards and credit cards are being used
increasingly and it is possibly to imagine a world where “money” in the
form of coins and paper currently will no longer be used. Even today, in
the U.S many places-especially filling stations-will not accept cash at
night for security reasons.

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Barter and the Double Coincidence of Wants

As long as specialization was limited, desirable trades were relatively
easy to uncover. As the economy developed, however, greater
specialization in the division of labor increased the difficulty of
finding goods that each trader wanted to exchange. Rather than just two
possible types of producers, there were, say, a hundred types of
producers, ranging from potters to shoemakers. The potter in need of new
shoes might have trouble finding a shoemaker in need of pots. Barter
depends on a double coincidence of wants, which occurs only when traders
are willing to exchange their product for what the other is selling. The
cobbler must be willing to exchange shoes for the pots offered by the
potter, and the potter must be willing to exchange pots for the shoes
offered by the cobbler. Not only might this double coincidence of wants
be hard to find but after the two traders connect they would also need
to agree upon a rate of exchange—that is, how many pots should be
exchanged for a pair of shoes? Increased specialization made the barter
system of exchange more time-consuming and cumbersome.

When only two goods are produced, only one exchange rate must be
determined, but as the number of goods produced in the economy
increases, the number of exchange rates grows sharply. Negotiating the
exchange rates among commodities is complicated in a barter economy
because there is no common measure of value. Sometimes the differences
in the value of the products made barter difficult. For example, suppose
the cobbler wanted to buy a home. If a home exchanged for 2000 pairs of
shoes, the cobbler would be hard-pressed to find a home seller in need
of that many shoes. These difficulties with barter have led even very
simple and primitive economies to use money, as we will see next.

Earliest Money and Its Functions

We have already discussed the movement from self-sufficiency to more
specialized production requiring barter. We saw that the greater the
degree of specialization in the economy, the more difficult it became to
discover a double coincidence of wants and then to negotiate mutually
beneficial exchanges. We should note that nobody actually recorded the
emergence of money. Thus, we can only speculate about how money first
came into use.

Through repeated exchanges, traders may have found that there were
certain goods for which there was always a ready market. If a trader
could not find a desired match or did not need goods for immediate
consumption, some good with a ready market could be accepted instead. So
traders began to accept certain goods not for immediate consumption but
because these goods would be acceptable to others and therefore could be
knew corn was always in demand. As one good became generally acceptable
in return for all other goods, that good began to function as money. As
we will see, anything that is used as money serves three important
functions: a medium of exchange, a standard of value, and a store of
wealth.

Medium of Exchange If a community, by luck or by design, can find one
commodity that everyone accepts in exchange for whatever is sold,
traders can save much time, disappointment, and sheer aggravation.
Separating the sale of one good from the purchase of another requires
something acceptable to all parties involved in the transaction. Suppose
corn plays this role, a role that clearly goes beyond its usual function
as food. We call corn a medium of exchange because corn is accepted in
exchange by all buyers and sellers, whether or not they want corn for
its own uses. A medium of exchange is anything that is generally
accepted in return for goods and services sold. Corn is no longer an end
but a means to an end. The end may be shoes, meat, pots, whatever. The
person who accepts corn in exchange for some product may already have
more corn than the entire family could eat in a year, but the corn is
not accepted with a view toward consumption. It is accepted because it
can be readily exchanged for other goods. Corn can be used to purchase
whatever is desired whenever it is desired. Because in this example corn
both is a commodity and serves as money, we call corn a commodity money.
The earliest money was commodity money.

Standard of Value As one commodity, such as corn, became widely
accepted, the prices of all goods came to be quoted in terms of corn.
The chosen commodity became a common standard of value. The price of
shoes or pots could be expressed in bushels of corn. Thus, not only does
corn serve as a medium of exchange but it also becomes a yardstick for
measuring the value of all goods and services. Rather than having to
quote the rate of exchange for each good in terms of every other good,
as was the case in the barter economy, the price of everything could be
measured in terms of corn. For example, if a pair of shoes sells for two
bushels of corn and a five-gallon pot sells for one bushel of corn, then
one pair of shoes exchanges for two five-gallon pots.

Store of Wealth Because people often do not want to make purchases at
the same time they sell an item, the purchasing power acquired through
sales must somehow be preserved. Money serves as a store of wealth by
retaining purchasing power over time. The cobbler exchanges shoes for
corn in the belief that other suppliers will accept corn in exchange for
whatever the cobbler demands later. Corn represents a way of deferring
purchasing power yet conserving that power until consumption is desired.
The better money is at preserving purchasing power, the better it serves
as a store of wealth.

When we think of someone selling one good in order to be able to buy a
second good, then the exchange of the first good for corn is only half
of the exchange. Goods are first exchanged for the commodity money,
corn; corn is -later exchanged for other goods. Breaking the exchange in
two is much more convenient than trying to work out a barter
arrangement, with its frequent delays and disappointments. With money,
the buyers and sellers need to have only one good in common instead of
two.

Any commodity that acquires a high degree of acceptability throughout
the economy thereby becomes money. Consider some commodities used as
money over the centuries. Cattle served as money, first for the Greeks
and then for the Romans. In fact, the word pecuniary comes from the
Latin word pecus, meaning «cattle.» Other commodity moneys used at
various times include tobacco and wampum (polished strings of shells) in
colonial America, tea pressed into small cakes in Russia, and dates in
North Africa.

Whatever serves as a medium of exchange is called money, no matter what
it is, no matter how it first came to serve as a medium of exchange, and
no matter why it continues to serve this function. So long as there is
something that sellers willingly accept in exchange for whatever they
sell—rather than looking around for goods they in particular would like
to consume—that article is money, whether it is animal, vegetable, or
mineral. The only test for money is that it be widely accepted in return
for goods and services. Some kinds of money perform this function well,
others not so well. But good or bad, it is all money.

Problems with Commodity Money

Corn does as well as some other commodities that have served as money
throughout history. But there are problems with most commodity moneys,
including corn. First, corn must be properly stored or its quality will
deteriorate; even then, it will not maintain its quality for long.
Second, corn is bulky, so exchange becomes unwieldy for major purchases.
For example, suppose a new home cost 50,000 bushels of corn. Many
truckloads of corn would be involved in such a transaction. Third, if
all corn is valued equally in exchange, people will tend to keep the
best corn and trade away the lowest-quality corn. The quality of corn in
circulation will therefore decline, reducing the acceptability of this
commodity money. Sir Thomas Gresham, founder of the Royal Exchange of
London, pointed out back in the sixteenth century that «bad money drives
out good money,» and this has come to be known as Gresham’s Law». When
moneys of different quality circulate side .by side, people tend to
trade away the inferior money and hoard the best.

A final problem with corn as with other commodity moneys is that the
value of corn depends on its supply and demand, which may vary
unpredictably. On the supply side, if a bumper crop increases the supply
of corn, corn would likely become less valuable, so more corn would
exchange for all other goods. On the demand side, any change in the
demand for corn as food would alter the amount available as a medium of
exchange, and this, too, would influence the value of corn. Erratic
fluctuations in the value of corn limit its usefulness as money,
particularly as a store of wealth. If people cannot rely on the value of
corn over time, they will be reluctant to hold it as a store of wealth.
More generally, since the value of money depends on its supply being
limited, anything that can be easily produced by anyone would not serve
well as commodity money. For example, dirt would not serve well as
commodity money.

Metallic Money and Coinage

Throughout history several metals were used as commodity moneys,
including iron and copper. More important, however, were the precious
metals— silver and gold—which have always been held in high regard. The
division of commodity money into units was often quite natural, as in a
bushel of corn or a head of cattle. When rock salt was used as money, it
was cut into uniform bricks. Since salt \vas usually of consistent
quality, a trader needed only to count the bricks to determine the
amount of money. With precious metals, however, both the quantity and
quality became open to question. Because precious metals could be
debased with cheaper alloys, the quantity and quality of the metal had
to be ascertained with each exchange.

This quality-control problem was addressed by coinage. Coinage, when
fully developed, determined both the amount of metal and the quality of
the metal. The use of coins allowed payment by count rather than by
weight. Initially, coins were stamped only on one side, but undetectable
amounts of the metal could be «shaved» from the smooth side of the coin.
To prevent shaving, coins were stamped on both sides. But another
problem arose. Because the borders of coins remained blank, small
amounts of the metal could be «clipped» from the edges. To prevent this,
coins were bordered with a well-defined rim and were milled around the
edges. If you have a dime or quarter, notice the tiny serrations on the
edge plus the words along the border. These features, throwbacks from
the time when these coins were silver rather than a cheap alloy,
prevented the recipient from «getting clipped.»

The power to coin money was viewed as an act of sovereignty, and
counterfeiting, an act of treason. In England the king extended his
sovereignty only to silver and gold coins. When the face value of the
coin exceeds the cost of coinage, the minting of coins becomes a source
of revenue to the sovereign. Seigniorage refers to the amount of
precious metal extracted by the sovereign, or the seignior, during
coinage. Debasement of the currency represented a source of profit for
profligate governments. Token money is the name given to coins whose
face value exceeds their metallic value.

Money and Banking

Early banks were little more than moneychangers, exchanging coins and
bullion (uncoined gold or silver bars) from one form to another for a
fee. Money was counted on a banque, the French word for «bench.»
Banking, as the term is understood today, dates back to London
goldsmiths of the seventeenth century. Because goldsmiths had a safe in
which to store gold, others in the community came to rely on goldsmiths
to hold their money and other valuables for safekeeping. The goldsmith
found that when money was held for many customers, deposits and
withdrawals tended to balance out, so a pool of deposits remained in the
safe at a fairly constant level. Loans could be made from this pool of
idle cash, and the goldsmith could thus earn interest.

The system of keeping one’s money on deposit with the goldsmith was
safer than leaving money where it could be easily stolen, but it was a
bit of a nuisance to have to visit the goldsmith each time money was
needed. For example, the farmer would visit the goldsmith to withdraw
enough money to buy a horse. The farmer then paid the horse trader,
which promptly deposited the receipts with the goldsmith. Thus, money
took a round trip from goldsmith to farmer to horse trader and back to
goldsmith. Because depositors grew tired of going to the goldsmith every
time they needed to make a purchase, the practice developed whereby a
purchaser, such as the farmer, wrote the goldsmith instructions to pay
the horse trader so much from the farmer’s account. The payment amounted
to having the goldsmith move gold from one stack (the farmer’s) to
another (the horse trader’s). These written instructions to the
goldsmith were the first checks.

By combining the idea of cash loans w4th checking, the goldsmith soon
discovered how to make loans by check. The check was a claim against the
goldsmith, but the borrower’s promise to repay the loan became the
goldsmith’s asset. The goldsmith could extend a loan by creating an
account against which the borrower could write checks. Goldsmiths, or
banks, in this way were able to «create moneys—that is, create claims
against themselves that were -generally accepted as a means of
payment—as a medium of exchange. This money, though based only on an
entry in the goldsmith’s ledger, was accepted because of the public’s
confidence that these claims would be honored. The total claims against
the bank consisted of customer deposits plus deposits created through
loans. Because these claims against the bank exceeded the bank’s gold
and other reserves, this was the first fractional reserve banking
system, a system in which only a portion, or fraction, of deposits were
backed up by reserves. The reserve ratio measures reserves as a
proportion of total deposits. For example, if the goldsmith had reserves
of $5000 but total deposits of$10,000, the reserve ratio would be 50
percent.

Paper Money

Another way a bank could create claims against itself was to issue bank
notes. In London, goldsmith bankers introduced bank notes about the same
as they introduced checks. Bank notes were pieces of paper that promised
to pay the bearer a specific amount in gold when presented to the
issuing bank for redemption. Whereas only the individual to whom the
deposit was directed could redeem checks, notes could be redeemed by
anyone who held them. Notes redeemable for gold or another valuable
commodity are called fiduciary money. Fiduciary money was often «as good
as gold» since the bearer could, upon request, redeem the note for gold.
In some ways fiduciary money was better than gold because it took up
less space and was easier to carry.

The amount of fiduciary money issued depended on the bank’s estimate of
the proportion of notes that would be redeemed for gold. The greater the
redemption rate, the fewer notes could be issued based on a given amount
of gold reserves. Initially, these promises to pay in gold were issued
by private individuals or banks, but over time governments developed a
larger role in their printing and circulation. The tendency to redeem
notes for gold depended on the note holder’s confidence in the bank’s
willingness to do so upon request.

Once fiduciary money became widely accepted, it was perhaps inevitable
that governments would begin issuing fiat money, which consists of notes
that derive their status as money by power of the state, of fiat. Fiat
money is money because the government says it is money. Fiat money is
not redeemable for anything other than more fiat money; it is not backed
by a promise to pay something of intrinsic value. You can think of fiat
money as mere paper money. It is acceptable not because it is
intrinsically useful or valuable but because the government requires
that it be accepted as payment. Fiat money is declared legal tender by
the government, meaning that creditors must accept it as payment for
debts. Gradually, people came to accept fiat money because of the belief
that others would accept it as well. The money issued in the United
States today and, indeed, paper money throughout most of the world is
now largely fiat money.

The Value of Money

Why does money have value? As we have seen, various commodities served
as the earliest moneys. Commodities such as corn or tobacco had value in
use even if for some reason they became less acceptable in exchange. The
commodity feature of the money bolstered confidence in its
acceptability. When paper money came into use, acceptability was
initially fostered by the promise to redeem it for gold or silver. But
since most paper money throughout the world is now fiat money, there is
no promise of redemption.

So why can a piece of paper bearing the image of Alexander Hamilton and
a 10 in each corner be exchanged for a large pepperoni pizza or anything
else selling for \$10. People accept these pieces of paper because they
believe others will do so. Fiat money has no value other than its
ability to be exchanged for goods and services now and in the future.
Its value lies in people’s belief in its value.

The value of money is reflected by its purchasing power—the rate at
which money is exchanged for goods and services. The higher the price
level is, the fewer goods and services can be purchased with each
dollar, so the less each dollar is worth. The purchasing power of each
dollar can be compared over time by accounting for changes in the price
level. To measure the purchasing power of the dollar in a particular
year, first compute the price index for that year, then divide 100 by
that price index. For example, the consumer price index for 1986 was
328, using 1967 as the base year. The value of a 1986 dollar is
therefore 100/328, or about SO.30 measured in 1967 dollars. Thus, a 1986
dollar buys less than one-third the goods and services purchased by a
dollar in 1967.

Too Much and Too Little Money

Money serves as a medium of exchange, a standard of value, and a store
of wealth. One way to understand these functions of money is to look at
situations in which money did not perform these functions well. Money
may not function well as a medium of exchange because there is too
little money, too much money, or because the price system is not allowed
to operate. With prices growing by the hour, money no longer represented
a stable store of wealth, so people were unwilling to hold money. With
rapidly rising prices, relative prices also became distorted, so buyers
and sellers had difficulty knowing the appropriate price of each good.
Thus, money became less useful as a standard of value—that is, as a way
of comparing the price of one good relative to another. Money still
served as a medium of exchange, but as larger and larger amounts of
money were needed to carry out the simplest purchases, money became more
cumbersome. Exchange demanded more time and energy. In short, when there
is too much money, the economy becomes less productive than when there
is an appropriate amount of money.

On the other hand, if there is too little money in the economy or if the
price system is not allowed to function, the economy may be reduced to
barter, and, as we have seen, barter is inefficient. For example, just
after World War II money in Germany became -largely useless because,
despite tremendous inflationary pressure in the economy, occupation
forces imposed strict price controls. Since prices were set well below
what people thought they should be, sellers stopped accepting money,
forcing people to use barter. Experts estimate that because of the lack
of a viable medium of exchange, the German economy produced only half
the output that it would have produced with a smoothly functioning
monetary system. The German «economic miracle» that occurred after 1948
can be credited in large part to that country’s adoption of a reliable
monetary system. It has been said that no machine increases the
economy’s productivity like properly functioning money. Indeed, it seems
hard to overstate the value of a reliable monetary system. Consider in
the following case study a more contemporary example of the official
currency failing to serve well as a medium of exchange.

Conclusion

Just as the division of labor creates the need for exchange, exchange
creates the need for money. With money, exchange need not rely on the
double coincidence of wants required with barter. People can sell their
labor in return for money to be used for future consumption.

Barter was the first form of exchange. As the degree of specialization
grew, it became more difficult to uncover the double coincidence of
wants required with barter. The time and inconvenience involved with
barter led even simple economies to introduce money.

Money serves three primary functions: a medium of exchange, a standard
of value, and a store of wealth. The first money was commodity money,
where a good such as corn served also as money. With fiduciary money,
the second type of money introduced what changed hands was a piece of
paper that could be redeemed for something of value, such as silver or
gold. The third type of money introduced was fiat money, which is paper
money that can not be redeemed for anything other than more paper money.
Fiat money is given its value as money by law. Most currencies
throughout world today are fiat money.